Poverty Reduction in Developing Countries: The Role of Private EnterpriseGuy Pfeffermann

The role of private enterprise in development has been neglected by scholars, governments, and aid organizations. This is regrettable: a vibrant private sector generates jobs, raises incomes, and makes better, cheaper goods and services available.

The positive contribution that private enterprises can make to development and poverty reduction is likely to be obvious to most readers. They would agree that, in the long term, economic development cannot occur without dynamic private companies. They would also agree that good government and efficient public administration are equally necessary. The success of Singapore shows what such a combination can achieve. Then why write an article on the subject? Many of the Seattle, Washington, D.C., Prague, and Davos protesters blame multinational corporations for retarding development, despoiling nature, and keeping wages down.

Not only is the development impact of private firms an emotional and contentious subject but research has tended to be compartmentalized, concentrating on only one of the many aspects of this subject—multinational corporations, small and medium-sized enterprises, microenterprises, the performance of privatized firms, foreign direct investment, private infrastructure, or corporate governance, to name a few—without looking at the bigger picture. Except in Marxist literature, little has been published about the development impact of private enterprise per se.

One possible reason for academic compartmentalization may be the way in which basic economic statistics—the raw materials of nationwide empirical research—are organized. The United Nations System of National Accounts, which governs the way the most essential economic statistics are collected and assembled in the United Nations' member states, does not draw a distinction between private and public firms; instead, the two are lumped together into "productive sectors" such as manufacturing, mining, and services. It is therefore impossible, in most countries, to trace over time the contribution of private firms to value added, investment, and incomes. Investment data for private firms are available in about 50 of the world's 200-plus countries, but, in the vast majority of countries, the value added and incomes they generate are unknown. (The World Bank Group publishes private investment data annually under the heading "Trends in Private Investment in Developing Countries" in the International Finance Corporation's Discussion Papers series as well as on the web at www.ifc.org/economics/pubs/discuss.htm.)

Escaping from poverty

There can be no doubt that, in today's affluent countries, poverty is far less widespread than it was in earlier times. In 1820, the average income per head in Finland, Norway, and Sweden was less than $1,000 at 1990 prices; hundreds of thousands of people emigrated from those countries to the United States, where income per head was $1,300. Today, these three countries are among the richest in the world.

It is also important to consider intergenerational changes, because income mobility can be high from generation to generation. In Brazil, for example, more than half of the persons surveyed recently who had grown up in poor families moved out of poverty. The majority of those who started their working lives in agriculture as unpaid family workers, or at age 10 or younger, are now living above the poverty line.

What has happened in Brazil has happened in the developing world as a whole. Income mobility is high, but this fact has not received much public attention. According to household income and expenditure surveys, the total number of persons whose incomes are less than $365 a year worldwide—those the World Bank calls the "absolute poor"—has not changed much since 1987. Considering the efforts made by governments and aid organizations, the stagnation of the very lowest incomes is disappointing and seems to indicate that no progress has been made in reducing poverty. However, since 1987 the population of the developing countries has increased by about one billion people. It follows that the number of persons living above the absolute poverty line has increased very substantially during the last 15 years; these persons either had never been among the "absolute poor" or had somehow succeeded in escaping absolute poverty. Examining how one billion people in the developing world stayed out of poverty or escaped it should teach us a lot about what is necessary to achieve large-scale poverty reduction.

How do people manage to escape absolute poverty? Household surveys show that the answer, in large part, is found in each country's rate of overall economic growth. Recent research confirms beyond doubt that economic growth is a necessary condition for poverty reduction (Dollar and Kraay, 2001). The impact of national growth on the incomes of the poorest 20 percent of the population is about the same as it is on society as a whole. That is, a doubling of GDP over 25 years—annual growth of 2.9 percent—was found to be associated with a doubling of the poor's incomes. This robust finding is drawn from 80 countries over a period of 40 years. A sobering corollary of the analysis is that the distribution of income within these 80 countries, which is mostly highly skewed, has hardly changed in 40 years.

The data also indicate that poor people do not suffer the biggest falls in income during economic crises and that openness to foreign trade benefits poor people as much as it does other economic groups, as do respect for the rule of law and fiscal discipline. Interestingly, the data suggest that curbing high inflation benefits the poor more than the rest of society. Furthermore, contrary to the view that the poor may have benefited from growth in the past but no longer do so in today's "globalized" world economy, the analysis shows that the positive relationship between growth and poverty reduction has not changed.

The role of private firms

Some of the events most closely related to economic improvement are finding a job, or a relative's finding a job, or moving to a better job. Indeed, job creation is a major—probably the major—path out of poverty. The most sustainable job creation is by firms, whether they are new, very small firms or larger enterprises expanding in a growing economy. In almost all developing countries, including China, private enterprises are the main source of new jobs. These include firms in all sectors of activity, large and small firms, domestic and foreign firms. Although government jobs also contribute to income mobility, attempts at deliberate job creation, whether by central governments or by state-owned enterprises, have nearly always been unsustainable. Public enterprises tend to lose money; eventually, many either collapse or become a drain on public resources.

The chart, which is based on investment data collected by the International Finance Corporation for about 50 countries, shows average levels of public and private investment, expressed as percentages of GDP, over the past three decades for three categories of developing countries: those whose economies grew slowly, by less than 3 percent annually; those that registered 3-5 percent annual growth; and the fastest-growing economies, with annual growth rates of more than 5 percent. Although public and private investment can be mutually supportive and the three groups had similar levels of public investment, those with more private investment enjoyed faster economic growth. Correlation does not necessarily imply causality; indeed, causality likely runs both ways: more investment, when it is of the right kind, may be conducive to faster growth, and rapid growth is, in turn, an incentive for private firms to invest in the future. Still, countries with poor investment environments and lower levels of private investment tend to experience mediocre growth, hence more enduring poverty.

Private firms also contribute to development in other ways that are crucial to economic development and poverty reduction:

In most developing countries, they generate a large portion of government tax revenues, without which there would be no sustainable base for funding public health care, education, social safety nets, agricultural research, and other critical expenditures.

In countries with competitive economies, leading private firms will constantly seek out information that has practical local uses; to remain competitive, other firms will emulate their behavior. In the process, executives and employees upgrade their human capital, productivity, and incomes, contributing to the diffusion of useful knowledge and techniques.

Over time, competitive firms improve the quality of products and make them more affordable, thereby boosting the purchasing power of consumers, including poor consumers. Indeed, in countries such as India and Brazil, some private companies have begun to focus on the poorer segments of the population as promising new markets.

Not all private enterprises in all environments generate jobs, investment, and human capital, however. Monopolies and oligopolies, high protection against competing imports, and government subsidies all undermine the ability of private firms to reduce poverty. Government measures that encourage competition are the best way to attack the concentration of power, oligarchy, monopoly, corruption, and other distortions that make efforts to help poor people ineffective. The weakening of favoritism, the elimination of excessive red tape, the regulation of natural monopolies, and the encouragement of liberalization all work to defeat the entrenched forces of privilege that perpetuate poverty. Widening markets through regional trade and currency arrangements, and increasing internationalization and the attendant liberalization undermine cozy arrangements.

Business environment

What can governments do to support the creation and expansion of companies that are financially, economically, socially, and environmentally sustainable? Besides improving health care, education, and macroeconomic conditions, and encouraging competition, governments can undertake institutional reforms that, over time, lower the costs of doing business and thus create a more favorable business environment. Such reforms encourage activities not only by foreign investors but also—and more important—by the thousands of local entrepreneurs who want to start or expand small businesses in agriculture, services, and manufacturing.

A number of enterprise surveys and other analytical work linking institutional factors and economic performance have been carried out in recent years. These analyses pinpoint areas in which reform is urgently needed in many developing countries. Among the findings are the following:

A strong relationship exists between the quality of the business environment and long-term national economic performance, including the pace of poverty reduction.

Enforcement of the rule of law—in particular, the extent to which governments enforce contracts between private parties (and between private parties and the state)—is crucial to long-term development and, as already noted, affects the poor as well as affluent members of society.

Respect for property rights (especially those of the poor) is highly correlated with long-term economic and social progress.

The efficiency of government in delivering services is also associated with economic progress.

In particular, a recent worldwide survey of 10,000 enterprises carried out during 1999 and 2000 under the leadership of the World Bank Group points to the leading obstacles to doing business identified by business managers and owners in developing countries. Constraints were ranked in order of perceived seriousness on a scale of 1 ("no obstacle") to 4 ("major obstacle"). The average score for perceived obstacles is, unsurprisingly, higher in developing countries (2.6) than in industrial countries (1.95). The developing country list of obstacles is topped by four items scoring an average of 2.9: taxes and regulations, financing difficulties, inflation, and political instability or uncertainty. The next most serious perceived obstacles—corruption, exchange rate problems, and "street crime, disorder, and theft"—score an average of 2.6. Analysis of these survey data for all countries suggests that investment and economic growth are related to certain key indicators of the quality of the investment climate. For example, foreign direct investment flows are positively associated with economic predictability and predictability of changes in law and legislation, and negatively associated with constraints imposed by taxes and regulations and exchange rate instability. Likewise, GDP growth within each of the regional groupings of countries is negatively associated with the severity of constraints imposed by taxes and regulations in general and, specifically, high tax rates, tax administration, and business-registration procedures.

More broadly, the pace of long-term economic progress is intimately related to the costs of doing business. So, for example, some East Asian countries have developed successfully in part because it is cheaper to ship manufacturing components by air to the east coast of the United States via Singapore than it is to ship the same components from the Caribbean, even though the Caribbean is much closer. Air freight from Singapore is extremely competitive, while governments in the Caribbean have restrictions on shipping capacity. In short, governments that improve institutions and welcome competition enhance the poverty-reducing impact of private firms.

The small companies—and start-up firms, in particular—that are crucial to long-term economic and social development are especially vulnerable to bad government (Weder and Schiffer, forthcoming). Poor policies and weak institutions hurt these companies more than they do others. Larger firms can better afford to protect themselves, even though protection comes at a cost. For smaller firms, "exiting" into the unregistered informal sector is often the only refuge. By discouraging enterprise creation and forcing small firms to go underground, many governments limit job creation and chances for upward social mobility. Furthermore, start-up and small enterprises are the seedbed of the middle class; the weakness of the middle class in the majority of low-income countries hampers economic and social progress.

Surprisingly, business environment surveys have not been used systematically by governments and international organizations until recently, yet they map out in considerable detail "where the shoe pinches" and what concrete steps could be taken to enhance the developmental and poverty-reducing impact of private firms. Indeed, international institutions providing financial assistance to developing countries might find sectoral adjustment loans designed to improve business environments to be useful tools in poverty reduction. Such loans would support governments willing and able to invigorate their economies by taking on vested interests and so give more people opportunities to escape from poverty. Indeed, the steps required to improve the business environment offer a practical framework for examining the particular development challenges faced by individual countries. They therefore constitute an essential component of a holistic approach to development, along with macroeconomic and social policy agendas.

References:
David Dollar and Aart Kraay, 2001, "Growth Is Good for the Poor," World Bank Policy Research Working Paper No. 2587 (Washington); also available on the World Bank's website at http://www.worldbank.org/research/growth/pdfiles/growthgoodforpoor.pdf.Guy Pfeffermann, 2000, "Paths Out of Poverty: The Role of Private Enterprise in Developing Countries" (Washington: International Finance Corporation).
Beatrice Weder and Mirjam Schiffer, forthcoming, "Firm Size and the Business Environment: Worldwide Regression Results," in the IFC Discussion Paper series (Washington: International Finance Corporation).
World Bank, forthcoming, "Voices of the Firms," available on the World Bank's website at http://www.worldbank.org/wbi/governance/.

Guy Pfeffermann is the International Finance Corporation's Chief Economist and an Adjunct Professor at the School of Advanced International Studies, Johns Hopkins University (Washington).